The Perils of AMT and Stock Options

Thursday, June 23, 2011

Disclaimer: I am not a tax expert or a lawyer. This blog post is based on my own story and my own understanding of tax law as it affected me. It should not be construed as professional tax advice. You should consult a qualified tax expert about your own situation.

If you work for a tech startup, it's likely that you have been granted some stock options in the company you work for. And, assuming you're in Silicon Valley, it's also likely that you'll be affected by the USA's Alternative Minimum Tax (also known as AMT).

I fit into both of these categories. I want to tell you how I became, in my own way, a victim of AMT.

You may well be aware that AMT can interact in quite a weird way with stock options. For example, several people were pushed into bankruptcy when the tech bubble burst in 2001. I'd heard about this, and I was aware that I needed to be very careful when I exercised my options. However, I didn't realize that I needed to worry about AMT as soon as I received my options.

Lesson 1: If you own ANY stock options, you need to worry about AMT NOW!!! Even if you are just out of college and have never paid taxes in your life!!

How are stock options supposed to work, at least in Silicon Valley lore? The typical story goes something like this:

Bonnie Brown was fresh from a nasty divorce in 1999, living with her sister and uncertain of her future. On a lark, she answered an ad for an in-house masseuse at Google, then a Silicon Valley start-up with 40 employees. She was offered the part-time job, which started out at $450 a week but included a pile of Google stock options that she figured might never be worth a penny. After five years of kneading engineers’ backs, Ms. Brown retired, cashing in most of her stock options, which were worth millions of dollars. To her delight, the shares she held onto have continued to balloon in value.

In more detail, this is how the mechanics of an employee stock option works:

When you are hired at a startup, you are typically granted a certain number of stock options, with a defined strike price. For example, you may be granted 10,000 stock options with a stike price of 10 cents. This means, in theory, that at some time in the future you will be able to purchase 10,000 shares in the company at 10 cents each.

The grant typically has a vesting schedule. A very common vesting schedule is for 25% of the options to vest after you have been with the company one year, and for the remainder to vest monthly, with one-sixteenth of the total options vesting every month. This means that, after you have been at the company for four years, all your options will have vested. (What does "vested" mean? Good question! We'll talk more about that below)

At some point you may want to exercise your stock options. This means actually buying the stock.

You typically lose your right to the options if you leave the company, whether by voluntarily resigning, or being fired or laid off. You will typically have a small amount of time, such as 90 days, to buy your stock after you leave the company. After that the options "expire" or are worthless. However, if you have "exercised" your options by buying the stock before this time, you can keep the stock even though you have left the company.

If you have exercised some options and thereby acquired some stock, you then hope for a liquidity event. This can be either an IPO or another company acquiring your company. You can then sell the stock, hopefully at a large profit.

That's the basic story, which I understood when I was granted my options. However, there are several details which may make millions (or at least several thousands) worth of dollars of difference!

Note: this blog is about employee stock options,which are typically of the kind referred to as "Incentive Stock Options" (ISOs) in the tax code. There are other kinds of stock options as well, such as those traded on the stock market by Wall Street speculators. Those stock options are taxed differently, and this blog post does not cover them. In this blog post, all references to "stock options" refer only to ISOs. Not all employee stock options are ISOs: you should check with your employer.

How the tax system will screw you up

The US has two systems of income tax. There is regular income tax, and there is Alternative Minimum Tax (AMT). In theory, everyone has to calculate both their regular income tax and their AMT, and then pay whichever is greater. In practice, the vast majority of AMT payers make between $100,000 and $500,000 per year, per household. People outside this range rarely pay AMT (but they could if they exercise stock options!)

Now let's look at how the two tax systems treat stock options:

Grant: not taxable under either regular income tax or AMT.

Vesting: not taxable under either regular income tax or AMT.

Exercise: not taxable under regular income tax, but taxable under AMT!

Sale: taxable under both regular income tax and AMT.

The key difference is exercise. Exercising a stock option is potentially a taxable event under AMT, even though it's not taxable under the regular income tax.

How AMT taxes the exercise of stock options

When you exercise your stock options, the IRS (the US tax authority) calculates what it calls the "bargain element". This is calculated as follows:

Bargain element = Fair market value - strike price

We already know what the strike price is (see above). But what's the "fair market value"?

For a stock that is traded on the open market (in other words, a post-IPO or public company), the "fair market value" is simply the value of the stock on the market, on the day you exercise your options.

However, for a stock that is not traded (e.g. a pre-IPO or private company), the IRS typically just asks the company how much its shares are worth. The company then asks an accounting firm to value it, based on sales, revenue, etc. This is often connected with the issuance of extra stock for refinancing, so the company has an incentive to make the value high. You theoretically have the right to challenge the "fair market value" reported by the company to the IRS, but in practice it's prohibitively expensive to do so (you would probably need to hire your own accounting firm to conduct its own, independent, valuation).

A real-life scenario

This is loosely based on my own experience, although I've altered the numbers a little to make the math easier.

Let's say you get in early at a startup, and are awarded 10,000 stock options at a strike price of 10 cents. You stay there four years, and you are therefore fully vested. At this point, you leave (maybe you get sick of the company, maybe you get forced out by company politics, maybe you are laid off). The company is still doing fairly well: it has customers and is profitable, but is not ready for an IPO yet.

You might think that you can just buy 10,000 stock options at 10 cents each, for a total of $1000. Right?

Wrong!

Because your company is doing well, it probably values itself fairly highly. Let's say it values its own stock at $10.10.

The IRS will assess a "bargain element" on your exercise of $10.00 ($10.10 - $0.10) a share, and will tax that at the AMT rate, which is currently 28%. Because you live in California, you will also have to pay state AMT, which is 7%. So the total tax you will have to pay is:

10.00 x 10,000 x (0.28 + 0.07) = $35,000

You thought that exercising your stock options would only cost you the $1,000 exercise price. In fact, it will cost you a total of $36,000 (the exercise price plus the AMT). Pretty big difference, huh?

What's even worse, you will have to pay the $35,000 tax, even though there is likely no way for you to immediately sell the stock you acquire. Most pre-IPO companies have no legal market in their stock (Facebook is a rare exception). So that $35,000 would have to be cold, hard cash out of your bank account.

In my own case, I couldn't risk the $36,000. I was forced to forego most of my options, even though I was pretty sure my company was going to go public in the next couple of years. To say I was pissed off would be an understament.

Lesson 2: Do NOT assume that you can always buy your stock for the strike price

This makes no sense! Why should I be taxed on an asset that I can't sell?

Good question! Ask Congress.

The AMT does kind of make sense, from one perspective. The way AMT looks at things, by exercising your options you are getting a valuable asset at a bargain price. The asset is still valuable, even though you can't immediately sell it. However, although this rule may make sense for venture capitalists, it makes no sense for regular software engineers.

What happens if my company never has an IPO and goes bankrupt?

You're really screwed. In this case, you have probably lost your $35,000 for good. (It's theoretically possible to reclaim it in later years via AMT credit, but that is paradoxically much more likely if the company goes public and you sell your stock at a profit).

Note that in 2008 Congress passed a special AMT refund to help people who had been hit with huge AMT bills from the tech stock bubble in the 1990s. However, this refund was only temporary (it expires in 2012) and only valid for AMT bills that had been incurred at least four years ago. So it won't help anyone who is in a dilemma right now.

Is there any way to avoid AMT?

If you sell your stock in the same calendar year that you exercise the options, then you pay no AMT. So, if you exercise in January, the company goes public in February, and you sell in, say, September, then you are OK.
However, stock acquired through employee stock options is typically subject to a "lockout" period of around six months after a company goes public. During this period, employees are forbidden from selling the stock. So you could still be in trouble even if your company goes public soon after you exercise.

What I should have done: Early Exercise

There is, however, one other way to avoid AMT. It's called "early exercise".

Let's take a step back. What does it mean for a stock option to be "vested"? I naively thought that it meant I could not exercise the stock option until it was vested.

It turns out that that's not completely true. If you are granted a stock option, you typically have the right to exercise it early, before it's vested.

How does this work? You typically pay the strike price for all your options upfront soon after they are granted to you. If you leave the company, the company will then buy back any unvested shares at the strike price. The overall effect is the same as if you had exercised the stock when it was vested.

The benefit of early exercise

The benefit of early exercise if that you can completely avoid AMT. Let's look at how this works.

Your strike price is typically equal to the "fair market value" of your company's stock at the time when you join.

Therefore the "bargain element" of your options is zero.

So, if you perform early exercise immediately after you are granted the stock, you pay no AMT.

In my own situation, I would have exercised my 10,000 stock options by paying $1,000 as soon as they were granted to me. Provided I filed the appropriate paperwork (see below) I would then pay no AMT.

(Another possible benefit of early exercise is that any gains when you sell the stock might be taxed as long-term capital gains rather than short-term capital gains. However, I'm not going to get into that discussion here).

The risk of early exercise

The risk of early exercise is that the company may go bust. In that case, I lose my $1,000. I can't even claim it as a tax deduction.

However, risking $1,000 is a heck of a lot different (to me at least) from risking $36,000 (or possibly even more) by waiting to exercise.

The crucial paperwork for early exercise

In order to avoid AMT with early exercise, it's vital to file something called an 83(b) electionwith the IRS within 30 calendar days of exercising the options. Most sources recommend mailing it by certified mail with return receipt so that you can prove that the IRS received it. If you don't do this, you lose the AMT benefit of early exercise.Lesson 3: Consider early exercise. If you do, don't forget to file 83(b) with the IRS.

Thanks for reading this. I hope that it helps you -- or that it at least provokes you to think hard about the way to deal with your own stock options. I know that I'll be exercising early at any future startups I go to. Good luck!

I would like to recommend the following external websites, which helped me in preparing this blog post:

Disclaimer: I am not a tax expert or a lawyer. This blog post is based on my own story and my own understanding of tax law as it affected me. It should not be construed as professional tax advice. You should consult a qualified tax expert about your own situation.